Subject: Regulation - Federal Reserve and Interest Rates

This article discusses the interest rates which are managed or
influenced by the US Federal Reserve Bank, a collective term for
the collection of Federal Reserve Banks across the country.

The Discount Rate is the interest rate charged by the Federal Reserve
when banks borrow "overnight" from the Fed. The discount rate is
under the direct control of the Fed. The discount rate is always
lower than the Federal Funds Rate (see below). Generally only large
banks borrow directly from the Fed, and thus get the benefit of being
able to borrow at the lower discount rate. As of April 1997, the
discount rate was 5.00%.

The Federal Funds Rate is the interest rate charged by banks when
banks borrow "overnight" from each other. The funds rate fluctuates
according to supply and demand and is not under the direct control of
the Fed, but is strongly influenced by the Fed's actions. As of April
1997, the target funds rate is 5.38%; the actual rate varies above and
below that figure.

The Fed adjusts the funds rate via "open market operations". What
actually happens is that the Fed sells US treasury securities to

banks. As a result, the bank reserves at the Fed drop. Given that
banks have to maintain at the Fed a certain level of required reserves
based on their demand deposits (checking accounts), they end up
borrowing more from each other to cover their short position at the
Fed. The resulting pressure on intrabank lending funds drives the
funds rate up.

The Fed has no idea of how many billions of US treasuries it needs to
sell in order for the funds rate to reach the Fed's target. It goes
by trial and error. That's why it takes a few days for the funds rate
to adjust to the new target following an announcement.

Adjustments in the discount rate usually lag behind changes in the
funds rate. Once the spread between the two rates gets too large
(meaning fat profits for the big banks which routinely borrow from the
Fed at the discount rate and lend to smaller banks at the funds rate)
the Fed moves to adjust the discount rate accordingly. It usually
happens when the spread reaches about 1%.

Another interest rate of significant interest is the Prime Rate,
the interest that a bank charges its "best" customers. There is no
single prime rate, but the commercial banks generally offer the same
prime rate. The Fed does not adjust a bank's prime rate directly,
but indirectly. The change in discount rates will affect the prime
rate. As of April, 1997 the prime rate is 8.5%.